The economic history of the last 30 years is the triumph of monetarism over neo-Keynesian economics. When conventional Keynesian measures proved incapable of taming the inflation and high unemployment of the 1970s, new Federal Reserve Chairman Paul Volcker made what his successor later described as one of the most important policy changes in the last 50 years. He raised interest rates to previously unthinkable levels in a successful attempt to reduce the money supply, which broke the inflationary cycle, and, after a brief recession, led to a great economic expansion that lasted for nearly 20 years.
In 1965, Milton Friedman was quoted in Time Magazine. "We are all Keynesians now," he declared, expressing a sentiment later echoed by President Richard Nixon when he took the nation off the gold standard. But 27 years later, on the occasion of Friedman's 90th birthday, the future chairman of the Federal Reserve essentially declared "We are all Friedmanites now" during a famous speech in which Ben Bernanke accepted, on behalf of the Federal Reserve, responsibility for causing the Great Depression. Friedman had made the charge in "A Monetary History of the United States, 1857-1960," an important work that for a brief time promised to prove as influential as "The General Theory of Employment, Interest, and Money" had been generation before.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.
– Gov. Ben S. Bernanke, On Milton Friedman's 90th birthday
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Those words sounded a lot funnier in 2002 than they do in 2009, with governments and currencies in crisis, unemployment climbing higher than the Fed's worst case scenarios, and the ominous specter of global depression lurking on the periphery of the world's economic consciousness. The Federal Reserve appears to be out of ammunition; it was forced to back down on its threats to purchase its own bills by an implicit rebellion on the part of the bond market that drove long-term interest rates higher. Friedman's monetarist theory appears to be in tatters, as the slashed discount rate and massive increase in the money supply have not had the expected effects and look rather like injecting venom instead of an antidote to a poisoned victim.
On top of that, the Federal Reserve's extracurricular interventions in areas well outside of its responsibility to manage the nation's money supply, including the housing market and corporate management, combined with its refusal to provide any information to Congress, has sufficiently irritated the politicians of both parties to such an extent that Rep. Ron Paul's bill to audit the Fed has so many co-sponsors that it is already guaranteed passage in the House of Representatives.
Bernanke can hardly be blamed for the subprime crisis, which is the result of Alan Greenspan's refusal to rein in the irrational exuberance of the tech, housing and credit bubbles. But he is absolutely responsible for the Fed's looting of the Treasury on behalf of its member banks; more money has been wasted on failing to stabilize the financial system than would have been required to pay off every single mortgage at risk of default in America. And he is certainly to blame for the Fed's arrogant refusal to answer to the elected representatives of the American people for how their tax money has been funneled to various unknown parties around the world.
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And with Bank of America CEO Ken Lewis now openly charging Bernanke with lying to the Joint Economic Committee about the pressure to which Lewis claims Bernanke subjected him to prevent Bank of America from backing out of the disastrous Merrill Lynch merger, the Federal Reserve chairman's credibility has never been weaker. This is significant because Obama and his advisers show a clear preference for a return to neo-Keynesian policies; their $787 billion stimulus plan is straight out of Paul Samuelson's neo-Keynesian textbook. Bernanke, on the other hand, has warned of a "vicious deficit cycle" created by government spending on this scale, which amounts to an implicit criticism of Obama's fiscal approach to the economic crisis.
Bernanke's term expires in 2010. If the Fed's extraordinary efforts to conquer the crash through monetarist policies are successful, all will be forgiven, he will be reappointed to serve another term, and will probably be regarded as one of the greatest, if not the greatest, Fed chairman of the last 100 years. If, on the other hand, Bernanke's optimistic green shoot-spotting proves to be illusory and the economy continues to contract in the fall, this will greatly increase the probability that Obama will appoint a new chairman with neo-Keynesian views and an orientation towards antevolckerian monetary policy.